*This is the first draft of the Primary Source column #1. The final version will be published at Jain Family Institute’s Phemomonal World Publications.
The Primary Source’s Raison D’être: Financial Stability Across the Market Structure
Jain Family Institute has launched a project called Primary Source, which provides a “forward-looking” and “structural” approach toward financial stability. This project uses “systemic fluidity” and the quality of “market structure” as the foundations of financial stability. In contrast to systemic risk, systemic fluidity refers to the flow of four market attributes across an invisible spectrum: collateral, risk, liquidity, and payments. It is a characteristic of a resilient market microstructure. Classical financial stability theories concentrate on the ex-post systemic risk, the type that drives system-wide breakdown, or ex-ante preventive liquidity and volatility indicators. In these models, systemic risks occur, and financial indicators fluctuate in a “black box.” This program departs from this classical approach and looks inside the black box.
Specifically, the quality of market structure determines systemic fluidity, captured by four essential flows. First, the collateral flow depends on the quality of the firms’ industrial organization. Collaterals move between different types of entities and for various purposes. Therefore, firms’ business models determine the shiftability of collaterals across the system. The second nexus of systemic fluidity is the flow of risk. Risk flow depends on the derivative markets’ institutional and engineering qualities. Derivative markets are the structure underlying the distribution of risk. The third element of systemic fluidity is the flow of funds. The flow of funds across the system depends on the quality of the liquidity in circulation. This quality is determined by the structure of the market for financial intermediation.
Finally, the flow of payments depends on the tendency of two systemically important market structures to hoard junk liquidity and siphon off high-quality claims. Our central insight is that the financial system continually transforms public claims into private claims, both secured collateralized and unsecured ones, through two different structures: the payment processing system and the firms’ liquidity and payment solutions. First, the payment processing mechanism has two stages: payment and settlement. Nonetheless, the type of claim in the former is usually of a lower quality than in the latter. Second, firms’ liquidity and payment solutions continually involve their balance sheets’ liquidity and maturity transformations. As a result, both structures tend to hoard bogus liquidity and siphon off public liquidity. Nevertheless, the system’s quality depends on the trust that relatively safe and secured monetary liabilities exist at every layer. These claims are from collateral-taking private entities or the government’s presence as a lender of last resort.
The four nexus of the market structure are collateral, risk, funding, and payments. These topics, usually in isolation from each other, have been a focal point in four strands of theoretical literature: (1) macroeconomic theories of financial intermediation, (2) microeconomic models of industrial organization, (3) empirical finance literature on market microstructure and (4) theoretical finance models of asset pricing and capital valuation. This project connects these pieces of literature, as they closely coexist in the real world, to examine the quality of the market structure. The program’s ultimate objective is to build a forward-looking financial stability framework founded on systemic fluidity and the quality of the market structure rather than systemic risk and the strength of certain activities or entities.
The project’s primary source is the financial institutions’ research papers and narratives. Our vision is to let the market speak in real time. At the same time, we use academic frameworks to cut through the many noises of such market-generated narratives and categorize the changes in the quality of market structure as structural, cyclical, and event-driven. The preliminary results will be published in monthly columns called “Primary Source” in the Phenomenal World Publication.
Figure 1: The Four Key Elements of Systemic Fluidity
- The Flow of Collateral: Financial System is A Web of Interconnected Balance Sheets
Every trade involves financial assets, also called securities. The flow of such securities is a nexus of system-wide fluidity. Traditional financial stability models use market liquidity as an indicator of securities market strength. However, while market liquidity is significant in this framework, it is not the only element of such resilience. Market liquidity is provided by a specific type of financial intermediaries, market makers, who use their balance sheets to make the market in securities. However, the collaterals flow between a wide range of institutions with different business models. These institutions include capital and cash providers (such as institutional investors and money market mutual funds), financial intermediaries (such as exchanges, brokers, cash and security dealers, and alternative trading systems), and users of capital (such as asset managers and securities firms). These players operate differently. Nonetheless, they are all part of the supply chain of collateral. The economic structures and balance sheet decisions of all these entities determine the financial ecosystem’s flow of collateral.
The flow of collateral, in this framework, depends on a feature of the market microstructure called the firm’s industrial organization. Industrial organization (IO) links firms’ strategic choices with significant market attributes, such as competition within an industry, systemic balance sheet positions, and the overall resilience of the market structure. The development of IO theory during the 1970s has narrowed the gap between the fields of business management and finance. As a result, the IO provides powerful insights into the relationship between different aspects of the security market, including market liquidity and firm-level decisions. Moreover, these firms include all the entities along the supply chain and not only financial intermediaries. Therefore, understanding firms’ industrial organization is essential for understanding the collateral flows that run through the pipes of the financial system.
Collaterals flow for different purposes, including secured funding, investment, short-selling, margin requirements, and lending by securities owners. Financial firms sometimes adjust their business strategies, such as Collateral Management and Assets and Liabilities Management (ALM). In doing so, they sculpt the market microstructure required for the collateral flow. On a firm level, these strategies can help these entities maximize their utility function, achieve higher investment returns, and reduce counterparty risks. They do so by strategically matching their assets and liabilities or adjusting the type of collaterals they accept from the counterparties. Such counterparties include various financial entities such as banks, broker-dealers, insurance companies, hedge funds, pension funds, asset managers, and large corporations.
From a more systemic and industry-level perspective, such adjustments imply changing the types of lending and investment activities they engage in. It also affects the kinds of liabilities they issue and the assets they acquire. As a result, firms’ business management practices can affect the industry. Indeed, the increase in securities lending post-2000, the secular decline in market-making post-2008 Great Financial Crisis, and the sell-off of the U.S Treasury securities in March 2020 are examples of the systemic impacts of such firm-level strategies.
Financial institutions with different motivations and industrial organizations move collateral across the system. Nonetheless, these firms continuously change their business management strategies. By viewing the different firms’ balance sheets holistically as a pipeline of collateral flows, we can uncover hidden vulnerabilities that result from interconnections and interdependence between these firms. Furthermore, we can better understand how shocks are transmitted and amplified between different markets and entities. Thus, combining the overlooked industrial organization of the non-intermediaries with that of the more well-known financial intermediaries helps pave the way to a new framework describing the structure of the financial system. This shows that while financial intermediaries are at the center of such flow, they are not the only entities. In this framework, we also investigate the dependencies between these central activities in the financial system and how they lead to new forms of risks and vulnerabilities in the new era of collateral flow.
- The Flow of Risk: Derivatives Make Collaterals Flow. At the Same Time, They Create Hidden Risks.
The flow of risk is a nexus of systemic fluidity. Derivative markets are the market-based structure for the distribution of risk across the system. These markets’ performance depends on various structures, such as dealing mechanisms, underlying assets, and the engineering of the traded securities. Traditionally, derivative strategies are considered essential for firm-level risk management and hedging purposes. For financial stability, however, derivatives are considered “toxic” instruments that must be centrally cleared. This is because derivatives have zero initial value, and the position taker does not have anything to put on the balance sheet. Therefore, they are off-balance sheets. The trader has simply taken a position with a derivative contract rather than “buying” or “selling” something tangible. The off-balance sheet aspect of the derivatives is the central and sole focus of the traditional financial stability frameworks.
However, derivatives’ net impact on systemic fluidity also depends on their role in stripping the risks from financial assets. In doing so, they become the parallel track required for shifting hedged collaterals across the financial industry. Derivatives separate the flow of risks (foreign exchange, interest rate, and credit risks) from the flow of collateral. In doing so, they have become the key to transforming collaterals into funding. Collaterals are the foundation of secured funding, just as access to funding is the basis for market-makers capacity to trade collaterals and provide market liquidity. Buying and selling assets move collateral across the system. At the same time, it creates financial risks that derivative transactions may hedge. Derivative markets provide a market-based structure to manage the risks and determine the value of collaterals.
Derivatives positions, therefore, determine the fluidity of collaterals as they reduce counterparty credit concerns and protect against different types of exposures. A financial instrument, including U.S. Treasury bonds, can be traded as at least three separate instruments. The asset can be used as collateral to obtain short-term funding and make payments. The other instruments are derivatives, including interest rate swaps (IRS) and credit default swaps (CDS). IRS is an essential vehicle of risk distribution. It shifts the interest rate risk. Similarly, CDS distributes the default risk from the issuer to the derivative holder. A robust institutional foundation in the derivative market that ensures the simultaneous distribution of risks and collateral is essential for maintaining system-wide fluidity. This aspect, which is relegated to the background in most financial stability frameworks, will be a critical parameter of our approach when assessing the systemic impacts of derivatives.
Derivatives are the parallel structures that make the flow of collateral and their usage as the backbone of secured funding possible. In addition, derivatives are also the ongoing swap of IOUs, mainly in the form of cash. This parallel loan construction creates a web of hidden short-term debts. As most of these liabilities are in the form of daily cash commitments, they can put the traditional bank-based payment system under pressure both within and across borders. For instance, investors continually swap fixed interest payments with floating ones for a fixed period in an interest rate swap. Similarly, in a credit-default swap, the derivatives issuer promises to make periodic payments to its counterparty as a kind of insurance premium. Their payments happen parallel to the debt issuers’ periodic interest or coupon payments, making the time pattern of the derivatives holders’ payments the mirror image of the issuers of debt securities.
The parallel loan structure of derivatives and their margin computation, or cash for margining, link them to the system-wide liquidity and funding conditions. A mark-to-market financial engineering technique makes derivatives’ actual cash flow commitments higher than their implied level. The disparity between the real and implied cash commitments can create system-wide liquidity risk. Mark-to-market means that the investors should pay for daily gains and losses, also called “margin calls,” when the market value of the underlying asset changes. Mark-to-market significantly alters the derivatives’ implied cash flow commitments. In doing so, it converts otherwise cash-rich institutions, such as pension funds, into vehicles of systemic liquidity risk.
Cash-pool investors’ business model is at the heart of such transformation. These institutions, such as pension funds, generally have two opposing roles in the derivative markets. First, they use derivative strategies to hedge significant pension plan liabilities against interest rate risks. In the meantime, because they hold large cash pools, they use derivative techniques such as Liability-Driven Investment (LDI) to earn higher yields. They take significantly speculative risk in this second position. These institutional investors’ dual role in the derivative market exposes them to significant margin calls during large price swings. As a result, derivatives transform cash-rich investors into vehicles of systemic liquidity vulnerabilities.
Finally, derivatives directly link the financialized commodity markets and the financial system. Commodities are one of the major asset classes that derive the values of derivative contracts. Any changes in commodity prices can generate excessive margin calls. Further, commodity traders’ financialized business model encourages them to establish speculative positions through derivatives. Derivatives allow them to use their information advantage as the market makers in an asset that underlies most derivative contracts. As non-financial corporations, however, they have considerable reliance on bank funding. As derivatives are mark-to-market, the large swings in commodity prices can expose them to significant and frequent margin calls. Commodity traders’ extensive usage of derivative strategies and over-reliance on bank funding can cause system-wide liquidity vulnerabilities.
Derivatives strip the risks from collateral and make them the backbone of secured funding. Nonetheless, the engineering of derivatives, especially their mark-to-market feature, makes them an essential linkage between markets for risk and markets for liquidity. Mark-to-market creates extra and unpredictable daily cash flows and can hide the true extent of liquidity risk in the system. And finally, derivatives can distribute risks between the commodity and financial markets. Derivatives link the flows of collateral, fund, risk, and commodities. Therefore, in this financial stability framework, we examine the “net” impact of derivatives on the quality of all these flows. Financial stability models that examine the role of derivatives without such a holistic view are limited in their effectiveness in monitoring systemic risks.
- The Flow of Fund: Financial Intermediation Is an Inherently Hierarchical Structure
The flow of funding across the system is a determinant of system-wide fluidity. The seamlessness of this flow depends on the quality of the monetary liabilities in circulation. This quality changes as the structures in the market for financial intermediation, such as the composition of players, activities, etc., evolve. The flow of funding is a layer of the flow of collateral, the backbone of secured lending. Nonetheless, it is based on somewhat different structures. The defining feature of collateral flows (and market liquidity) is that it is delivered in the long-term capital market. On the other hand, funding is provided in the short-term money market. At the same time, the flow of both funding and collateral depends on the quality of assets that underlie them. The shiftability of funding depends on the quality of monetary liabilities in circulation. Nonetheless, similar to the quality of different collaterals, monetary liabilities’ quality can vary widely. This framework focuses on the market microstructure that generates this inequality.
The microstructure of the funding market is defined as how the different traders (both on the sell-side and buy-side) share their responsibilities and roles. In the financial ecosystem, short-term monetary liabilities are produced, traded, and priced in the market for financial intermediation. In this market, both sell-side (liquidity providers) and buy-side (liquidity takers) constitute the pipeline that moves funds across the system. The market for short-term funding, known as the market for financial intermediation in the literature, has two sides: the buy-side and the sell-side. The buy-side is made of buyers of financial intermediation and funding, such as asset managers. They are the liquidity takers.
In contrast, the sell-side, made of banks, dealers, and brokers, are the providers of financial intermediation. These firms provide liquidity and shed light on the market valuation of monetary instruments. Indeed, the business model of liquidity providers is so crucial for liquidity conditions that it has been the primary motivation behind practitioners’ monitoring of market microstructure evolutions. The resilience of the pipeline that moves funding depends on the dynamics of both the sell-side and buy-side.
In the real world, not all the players on the sell-side provide the same quality of funding liquidity. The hierarchy of liquidity providers, ranked by their business model and the type of intermediation, is an essential characteristic of the financial intermediation industry. Some type of financial intermediation does not lead to a stable provision of traded liquidity. For instance, a traditional financial intermediary simply connects cash-rich to cash-deficit agents rather than making the market for funding. Similarly, the modern brokerage business only connects different counterparties and provides information about fair prices through financial analysis. These sell-side entities provide liquidity only by connecting traders with opposing needs. This type of intermediation provides conditional liquidity.
In contrast, market makers, including dealers, are the source of continuous liquidity. This is because they are uninformed (unbiased) liquidity providers and trade liquidity with any interested trader. When a dealer warehouses monetary instruments, it creates positions, a book, in those instruments. In this case, the dealer establishes long positions in certain assets and short in others. By running an inventory book, a dealer incurs certain risks. It does so to earn a reward- profits. As long as a monetary liability is in a dealer’s book, that liability creates some credit risk for the dealer. Whether the dealer sheds that credit risk when it trades out the claims depends on factors beyond the dealer’s control. Nonetheless, this is how they make the market. Market makers, such as dealers, use their balance sheets and absorb unwanted inventories for a reward. In doing so, they provide continuous liquidity, prices, and liquidity risk premia. This puts market-makers at the top of the sell-side hierarchy. Other intermediaries that provide conditional liquidity are at the lower layer.
Similarly, the buy-side’s access to funding is hierarchical for two reasons First, not all monetary liabilities in circulation have high quality. Second, high-quality funding is unequally distributed. The scale of access captures both dynamics. For example, some financial firms at the top of the hierarchy have access to highly convertible and liquid monetary instruments, including central bank reserves. Others, however, should pick mostly from a menu of shadow funds. Shadow funds are expensive and provided by low-rated and unstable liquidity providers.
The frontier between access to high-quality liquidity and shadow funds is blurry during standard periods. In these times, the elasticity of credit and the high velocity of shadow funds (the frequency at which these funds are traded within a given period) makes the hierarchy non-binding and invisible. In contrast, during a crisis, the double hierarchies of the sell-side and buy-side bind simultaneously and to the fullest extent. In this period, not only does the separation of roles between the sell-side and buy-side become unmistakable, but the different qualities of liquidities in circulation also become evident. When this happens, the pipeline and infrastructure that circulates funding, in dynamics between the sell-side and buy-side, become the vessel for moving liquidity risk across the system.
The linkage between the sell-side and buy-side, rather than the resilience of a few systematically important financial institutions, can aggravate an otherwise idiosyncratic funding problem in one layer into a system-wide liquidity crisis. Understanding the linkages between funding, collateral, and derivatives of the financial web is necessary for exploring the financial system as a dynamic process rather than a snapshot. To understand the financial ecosystem, we first must map and surveil interactions between different entities rather than the balance sheet of a few systemically essential firms in isolation and the transformation of collateral, derivatives, and funding to varying layers of the ecosystem. Our systemic fluidity framework shows the complex movements and shifts. In contrast, the financial industry typically focuses on cash and balance sheet items that do not capture the fluidity of these collective elements.
- The Flow of Payment: Junk Liquidity Siphons Off Public Claims
The flow of payments is the last element of systemic fluidity. The payment system is the real-life stress test of the system-wide tendency to hoard junk liquidity and siphon off high-quality claims. The financial system continually transforms public claims into private claims. These private IOUs can be either safe and secured by collaterals or unsecured. Significantly, this transformation happens through two different channels: the payment processing system and the firms’ liquidity and payment solutions. First, the payment system has two layers: payment and settlement. In the meantime, the quality of claims in the first stage is usually lower than in the final stage. Second, firms’ liquidity and payment solutions continually transform their balance sheets’ liquidity and maturity. Both these channels and structures tend to hoard bogus liquidity and siphon off public liquidity. Nevertheless, the system’s quality and the flow of payments depend on the trust that relatively safe and secured monetary liabilities exist at every layer. These claims are from collateral-taking private entities or the government’s presence as a lender of last resort.
The liquidity transformation that occurs in the system has two separate roots. The first component is the intrinsic feature of the payment system. Every payment starts and ends with liquidity. However, the quality of funding instruments required to settle each stage differs. Payments are processed in two phases. The first stage, known as the payment stage, is when the promise to make the final payment is made. These promises to pay are usually funded by exchanging collateral (secured funding) or short-term monetary liabilities (unsecured financing). At this stage, at each layer of the hierarchy, payments happen as a conversion of the lower-quality liabilities into higher-quality ones (issued by entities at the higher layer of the sell-side hierarchy). In the first stage, the hierarchical structure of funding instruments remains invisible.
However, this hierarchy becomes binding in the final stage of payment. At this stage, the final settlement, all the net payments, should be settled and cleared. The final clearance happens only if the payment system can convert the remaining payments into the highest-quality form of money, such as the central bank’s reserve or cash. A systemic problem will happen if this convertibility is not economical. In this case, the conversion, if it happens, will be at a penalty or negotiable at prices lower than par and cause system-wide missed payments. The continuity of liquidity transformation in the first and last stages of payments determines the resilience of payment flows. The payment flows seamlessly only if there is a systemic trust that relatively safe and secured monetary liabilities exist at every layer.
The second channel reflects the corporates’ cash management strategies. Various types of financial and non-financial participants are involved in the payments ecosystem. Importantly, all these large firms use somewhat similar liquidity and payment solutions to meet their daily cash flow constraints. For instance, the two core and standard liquidity management techniques are netting and cash pooling. Netting aims to reduce funds transfer between subsidiaries or separate companies by settling the funds to a net amount. Cash pooling allows enterprises to combine positive and negative positions from various bank accounts into one account. This aims to reduce short-term borrowing costs and maximize returns on short-term cash. Corporate treasurers’ payment solutions, an often overlooked aspect of systemic risk, link the business models of otherwise wildly divergent firms with each other. As a result, the liquidity transformation that happens at the firm level can leave industry-level footprints on the payments system.
Corporate treasurers manage liquidity and payment costs by not leaving liquid assets uninvested for at least two reasons. First, the monetary instruments earn very low-interest rates. Second, the wholesale cash is uninsured and exposes the corporates to credit risk. If and when funding is required to ensure the payment accounts remain in a positive balance position, they convert these investments back to more cash-like instruments. As a result, they change the level of liquidity transformation daily and expose the system to systemic forecasting errors.
In standard times, these strategies might not be consequential. Large corporates have access to short-term money market funding. In this system, money market dealers act as the ultimate corporate treasurers and correct their cash flow miscalculations. In doing so, money market dealers become the linkage between payment flows and short-term funding. In crisis times, however, this link might break. Under such circumstances, market makers usually exit the market. In this case, the full force of the liquidity mismatch embedded in the financial ecosystem becomes visible to everyone. Corporate treasures’ liquidity and payment strategies can expand the current level of liquidity transformation in the ecosystem and make its management unsustainable. In such circumstances, the payment system that inherently depends on the system-wide ability to manage such transformation will break down.
- Conclusion
Although invisible, market microstructure is the infrastructure underlying the financial system. In particular, its destabilizing dynamics can vividly disrupt the financial system’s fluidity captured by the (1) shiftability of collateral, (2) the distribution of risk, (3) the transmission of liquidity, and (4) the payment flows. Although these four pillars of systemic fluidity can be examined separately and selectively, they are inseparable features of real-world market structure. At the same time, one of the byproducts of recent microstructure evolutions, and the consequent turmoils, is that it has demanded us to merge our academic and practical perspectives to uncover how the system works as a whole.
Derivatives and collaterals are inseparable backbones of financial stability. In a complete market, market participants trade collaterals and hedge risk exposures by entering derivatives contracts. Therefore, systemic risk can be understood as the residual risk left in a portfolio when all the other risks have been hedged through all possible derivative strategies. In this environment, the financial stability models focus on the unhedged and uncovered risks in the balance sheets of a few systemically important entities. However, in our model, the derivatives’ role as systemic stabilizers goes beyond these micro, firm-specific unhedged positions. Instead, the stress is on the resilience of the market structure that enables the trading and engineering of such instruments in the first place. The idea is that these infrastructures facilitate or jeopardize the derivatives’ capacity to “shift” risk across the financial system. Further, institutional details, such as the trading mechanism and the dealing system, determine whether derivatives are the vehicles of risk distribution or the sources of systemic risks.
Systemic fluidity also depends on the flow of funds. This framework examines two inherent characteristics of the market structure that determine the ability of the system to shift funds. The first feature is the hierarchy of financial intermediation. The hierarchy captures the notion that not all intermediaries provide and move liquidity equally efficiently. The second premise is the hierarchy of access to liquidity- an idea that not all intermediaries have access to high-quality monetary claims. These hierarchies make liquidity risks and premiums vital features of the financial system. Liquidity risks arise when a financial institution cannot meet its obligations without incurring unacceptable losses. However, not all liquidity risks become systemic. Instead, they threaten the financial ecosystem when the transmission and flow of funds are structurally impaired.
The financial system is inherently hierarchical. The dynamics of the hierarchies, whether they impose discipline or elasticity into the system, systemically affect liquidity distribution. Liquidity risk can tax firms’ daily cash flow management and lead to systemic missed payments. All payments have two stages which start and end with liquidity. In the first stage, payments are made by being postponed. In other words, institutions make their payments using credit instruments that can be convertible to more liquid assets. However, in the last stage, the financial system should settle and clear the remaining net payments. In this final settlement stage, only the best form of monetary claims can clear the payments. Therefore, the liquidity mismatch, and its dynamics, are the key to making or breaking the payment system.
To sum up, JFI’s Market Structure project introduces a financial stability framework based on the quality of the market structure, as apparent in the breadth of its fluidity. The program surveils this quality by examining the flows of collateral, risk, fund, and payments. Our forward-looking financial stability framework differs from other financial stability models with preventive rather than an after-the-fact compass. Market structure is the epicenter rather than an unwelcome complexity of our framework. This approach categorizes vulnerabilities as structural, cyclical, and event-driven. Therefore, instead of monitoring liquidity and volatility indicators, we look inside the black box of the market structure, where market participants and regulators’ tangible and pressing concerns are rooted.